Obsidian is a block created whenever Water touches Lava. When this occurs, the Lava or Water (whichever is below the other material) becomes Obsidian. It can only be mined with a Nightmare Pickaxe/Deathbringer Pickaxe or better. However, if the player creates obsidian directly on their spawn point (not a bed) and then teleports back there, the obsidian will be broken. This is the only other method of mining obsidian other than using bombs.01:31

Terraria - Obsidian Generator

Obsidian can be crafted into an Obsidian Skull, an accessory that provides protection from ores such as Hellstone and Meteorite ore when equipped. Obsidian is also a component required for crafting Hellstone Bars, as well as Obsidian Skin Potions. Obsidian is hard to find naturally due to Water rarely spawning on Lava, but the use of a Bucket makes gathering Obsidian much easier. If you don't have a Nightmare Pickaxe you can also use Dynamite or Bombs to blow up the ore and gather it, although caution is advised; Bombs being the safer of the two options due to their smaller explosion radius.

The underworld will be partially flooded, rendering the surfaces of some lava pits harmless.

The water will eventually drain out due to the underworld's intolerance to water.

When mining Obsidian from lava pits in this fashion, you will need a Nightmare Pickaxe or Deathbringer Pickaxe, as bombs are too sloppy. Stand directly on the Obsidian block of choice and mine it. Then fill it in with a non-falling block. Any other way and the Obsidian will either burn up in lava or you will.

Building a simple Obsidian farm:

A simple obsidian farm

Build a large container (about 20x20) out of blocks.To avoid accidents, be sure to use a sturdy material such as Dungeon Bricks.

The large container should fill completely with Obsidian within minutes.

Trivia

Prior to 1.0.2 Obsidian could be mined using any pickaxe. In patch 1.0.2 and later versions, Obsidian can only be mined with a Nightmare Pickaxe or better.

Even though Obsidian is of White rarity, it doesn't get destroyed by Lava when completely submerged.

Obsidian can be broken if it is created at the spawn point of the player. When they teleport back to it, they will break the obsidian. This only works if the obsidian is actually above the ground where the player spawns.

Obsidian doesn't form when water pours onto a block of lava which has an environmental doodad submerged in it. The water will keep draining and annihilating until the doodad is removed.

When portrayed in game, obsidian appears to be a purplish-black color, even though in real life obsidian is black. This is most likely due to the fact that a completely black block wouldn't be aesthetically pleasing.